Financial Developments in China and Implications for Hong Kong

Speeches

28 Apr 1995

Financial Developments in China and Implications for Hong Kong

Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at the Regional Conference on "China's Economy and its influence on Hong Kong Macau and Taiwan", the University of East Asia Alumni, 28 - 29 April 1995, Macau)

Mr. Chairman, Distinguished Guests, Ladies and Gentlemen,

I am very honoured to be invited to speak at this important Conference on China's Economy 2000 and its implications for Hong Kong. I would like to thank the University of East Asia Alumni for organizing this Conference and bringing together so many distinguished experts to share their visions of the development of China on Hong Kong, Macau and Taiwan.

By definition, experts do not agree on anything. They say that if you have ten economists, you are likely to get eleven opinions. All experts agree at least on one subject: it is very difficult to forecast the future. I do not pretend to be a futurologist, and will instead try to present a few scenarios by other economists, and ask what would be the implications on the financial sector, especially that of Hong Kong, Macau and Taiwan.

China 2000

China's resurgence into the global economy has been nothing short of astounding. Over the last 15 years, China has grown on average by 9.3% per annum. Between 1980-94, trade has grown on an annual average of 14%, nearly 3 times world annual average growth of 5.5%. China is today the 11th largest trading economy, with a share of 2.8% of world trade, compared with 0.8% in 1980.

On various assumptions, a number of forecasters, including the World Bank, have suggested that China would become one of the world's largest economies [if not the largest] by roughly the year 2020. The World Bank has in fact estimated that the Chinese Economic Area [China, Hong Kong and Taiwan] would, in purchasing power parity [PPP] terms, be larger than the US by the year 2002 [Table 1]. In 1993, the CEA's GDP as a group amounted to US$875 billion or less than one-fifth that of Japan, but the combined trade (imports + exports) of the CEA exceeded that of Japan1.

The importance of the CEA as a global growth pole cannot be underestimated. World Bank forecasts2 suggest that "the degree of these three economies' trade and investment integration is such that they are close to being a single economic unit today and will, in all likelihood, be even more so tomorrow". Assuming that China would grow by 8.5% and 7% for the period 1990-2000 and 2000-2010 respectively, 5.0% and 4.5% respectively for Hong Kong and 6.5% and 6.0% for Taiwan, the World Bank forecasts that the CEA would account for 17.1% of world output and 10.3% of world exports of manufactures [Table 2].

These estimates are not wildly out of line with the growth experience of the historical growth of the US, Japan, South Korea or Taiwan [Table 3]. There are several features of this growth that are worthwhile highlighting, since these will have implications for the financial sector, which I will refer to later.

  • China's growth has been powered by its growth in trade, which has increased from less than 10% of GDP in 1978 to 56% in 1994. This is a notable success of its open-door policy.
  • Between 1991-93, China was the world's largest recipient of foreign direct investment. Hong Kong accounts for roughly 60% of that investment, with Taiwan investment amounting to as much as US$15 billion up to 1994(3)
  • Chinese foreign exchange reserves have grown very rapidly, doubling in 1994, to reach over US$58 billion at end March 1995, exceeding that of Hong Kong. China, Hong Kong and Taiwan are three of the world's top seven holders of foreign exchange reserves, with a total of US$200 billion, exceeding that of Japan.
  • It is envisaged that the renminbi will become convertible by the year 2000.
  • As in the case of other economies, the Chinese economy will increasingly shift from primary industries to tertiary industry, with greater development of the services sector. Between 1980 to 1993, the service sector has grown from 21% of GDP to 27% of GDP. Total trade in services has risen over the same period from 8.7% of total trade in goods and services to 11%.
  • China has a high savings level, averaging 38% of GDP over the period 1980-93, compared with national investment levels of 37% of GDP. The difference, represented by the current account deficit in the balance of payments, was roughly 1% of GDP.

Implications for the Financial Sector

The growth of the financial sector depends on the level of national income, domestic savings and the stage of development of the financial system. China's financial system is still largely banking-oriented, with deposits with the banking system forming the bulk of household savings. The domestic financial sector comprises essentially three major financial products: banking deposits, equity and debt. There is of course a further element of savings, and that is in foreign financial instruments. Since exchange control still exists on the capital account in China, I shall focus only on the development of the domestic financial sector.

If we look at the experience of the industrial economies, using the USA as an example, the size of the three key markets in the financial sector are in the following ratios: Deposits as represented by M2: 63%; bond market 105%; and equity market 66% of GDP [Table 4]. By comparison, the M2/GDP ratio for China is already extremely high, at 96%, not that different from Japan (110%) and Hong Kong (108%), although smaller than Taiwan (170%).

Thus, it seems to me that as the economy matures, Chinese household savings in the years to come will still be ploughed into the banking sector, but its importance will decline relative to two other major areas of savings, namely the bond and the stock markets.

The international experience in the phasing of financial development is particularly interesting, as can be seen in Table 4. If we look carefully at the experience of the NIEs, especially Korea, Taiwan, Thailand and Hong Kong, you will notice that in the early stages of financial deepening, the banking market was the major form of savings. As income per capita increases, more savings would be ploughed into the stock market, and at higher levels of income, the debt or bond markets come into maturity. Thailand, which has a nominal income per capita equivalent to Chinese per capita income on a PPP basis (roughly US$1,900) is a good example. By 1992-93, the stock market capitalization was already as large as total banking assets, and yet the bond market was only 5% of GDP.

There are several reasons for this sequence of development of banking, equity and bond markets. Firstly, savings in currency and bank deposits constitute the most liquid and safe form for households, who also use the banking system as the payments mechanism. Secondly, as the economy grows with the development of enterprises, the household sector can share in the wealth creation through the equity market. The risks are higher, but the returns can outweigh the risks as long as the economy grows. However, as the economy matures and the population begins to age, the demand for both longer-term savings and by implication, safer debt instruments also begins to grow. Larger and larger pools of provident, pension and insurance funds naturally generate the demand for debt instruments, leading to the creation of the bond market.

This trend seems to be true also in the development of the Chinese financial sector. The development of the equity and bond markets in China will be a major engine of growth in the transformation of the enterprise sector for two key reasons:-

  • The equity market has to grow relative to the bank credit market, if only to address the fundamental shortage of capital funds for the state-owned enterprises. State-owned enterprises (SOEs) around the world have high leverage, and as long as they do so, it is difficult for monetary policy to operate. Increases in interest rates would hurt the SOEs more than private sector firms, mainly because the SOEs have higher leverage. On the other hand, SOEs will never feel the interest rate "pain", because they can always run to the state for further assistance. Restoring the debt equity leverage ratio of the SOEs to a more sustainable and prudent level is a technical question of effectiveness of macro-policy, as well as a risk-management question at the micro-level, and not one of political economy.
  • Developing the bond market has essentially three basic objectives. The first is to fund the budget deficit on a sound basis. The second is to produce a tool for monetary management. The third is to provide an instrument to fund long-term investments, particularly in the infrastructure and housing areas.
  • Much has been said already about the tremendous future for infrastructure funding in Asia. The ADB and World Bank have both produced estimates that infrastructure projects in Asia would require roughly US$1.5 to 2.5 trillion. China alone is estimated to account for one-third of this investment. Naturally, the funding requirements are very large, thus exciting many investment bankers. However, we tend to forget that the capacity of the foreign sector to finance China's investments is quite limited. According to OECD standards, a country can safely run a current account deficit of not more than 2.5% of GDP without incurring excessive external debt. A 2.5% of GDP current account deficit in 1994 terms would already be US$13.5 billion for China. In the year 2000, that sum could be US$42.5 billion, not easy for the capacity of the international capital markets to digest. Considering that domestic savings in 1994 is in the order of US$209 billion, much of the infrastructure funding will have to be in renminbi.
  • The domestic funding of the large investment programme in China will inevitably have to depend on the creation of a deep and liquid bond market. Domestic fixed investment, excluding inventory, comprises essentially three components: infrastructure, equipment and residential housing. The international experience is that the ratios are roughly 25%, 50% and 25% respectively. In other words, plant and equipment is half of total domestic investment, while infrastructure investments would be roughly the same order as residential housing. The safe funding of these long-term investment would be a major challenge to China.
  • The experience of the USA may be helpful to illustrate the challenges involved. In 1968, the US banking system directly financed 56.7% of total residential mortgages in their books. This was basically illiquid, since the banks financed 30-year mortgages with short-term bank deposits. With the evolution of mortgage-backed bonds, initially guaranteed through the Federal National Mortgage Association (Fannie Mae), the banking system currently financed 28% of residential mortgages directly, while the secondary mortgage market financed 46.7% of all residential mortgages.
  • In the decades ahead, the demand for residential housing in China will be a major boost to domestic investment and expenditure, creating the domestic engine for growth, in complement to the investment in infrastructure. Such funding will be large by any standards. If the rough forecast of Chinese GDP of US$1.7 trillion is correct, then domestic investments in the year 2000 of the order of, say, US$680 billion [40% of GDP] would be required. If we crudely assume that such investments would be funded one-third each by the banking system, the stock market and the bond market, we would be looking at funding of roughly US$230 billion by each sector.

Scenario for Financial Sector 2000

Based upon the international experience found in Table 4, and the published estimates made on GDP by various experts, I have tried to cast a scenario for the financial sector for China, Hong Kong and Taiwan by the year 2000. I wish to stress that Table 5 is not a forecast. It is only one possible scenario, based upon numerous assumptions. If the GDP of the three economies turn out to be roughly US$2.5 trillion by the year 2000, as estimated by various sources, including the World Bank and the Chung Hua Institution for Economic Research, then we could be in a position to "guesstimate" the size of the financial markets, if they reach roughly the same size/GDP ratios for comparable economies.

For example, if the Chinese M2/GDP ratio reaches that of Japan by 2000, i.e. 110%, the banking system would be nearly US$1.9 trillion in size. Similarly, if China's stock market capitalization reaches 40% of GDP by 2000, already higher than that of Germany, then the market size would be roughly US$680 billion. Assuming also that the Chinese bond market takes off and reaches 40% of GDP, while Hong Kong's smaller needs reaches 25% of GDP, about the same level currently as Korea, then the bond markets of the CEA would reach a size of US$638 billion.

Table 5 can now be put into an international perspective. The size of the Chinese Economic Area as projected using the PPP approach greatly exaggerates its economic importance. In terms of current value projections, the size of the financial markets is impressive, but by no means out of proportion with current global markets. For example, the banking system in the year 2000 will still be less than 90% of US M2 in 1994. The stock market capitalization by 2000 would also be less than 60% of the Japanese stock market or just over half of the US stock market capitalization in 1994. Finally, the bond market size, at around US$839 billion, would be less than one eighth of the US bond market of US$6.7 trillion in 1994. In other words, the financial market size would be impressive by world standards, but would not by any means challenge the financial markets of Japan, Europe or the US for top place.

Implications for Hong Kong

Assuming that the rough scenarios that I have sketched out are broadly in order, then the future of Hong Kong as the primary international gateway into China and major financial centre must be very bright indeed. Hong Kong has already transformed herself from a major manufacturing economy into a services sector. Between 1983 to 1993, the services sector's share of GDP has risen from 62.4% to 77.4%, while the services sector's share of employment has risen from 53.8% to 71.4%.

Trade in services is already a major source of income for Hong Kong. In 1994, Hong Kong's trade in services amounted to 16% of total trade in goods and services. Hong Kong will play a major role in the services sector in China in the year 2000 because she has all the skills, technology and infrastructure in the areas that China lacks today, such as modern banking, marketing, business management and especially in the area of finance. Such skills cannot easily be duplicated. Hong Kong has arguably the third largest concentration of financial sector employment in the world with nearly 350,000 persons, next to London (800,000) and New York (400,000).

Again, using linear extrapolation, if the services sector continues to grow along its recent path, by the year 2000, the services sector's share of GDP in Hong Kong would rise to 85%, one of the highest in the world, while services trade as a proportion of GDP would rise from roughly 40% to nearly 44% of GDP [Figure 1]. Hong Kong would truly be a major international services centre, serving not only China, Taiwan and the Region, but also the rest of the world.

The speakers on the stock market are much more qualified than I am to talk on the role of Hong Kong in the development of the equity market in China. However, I am convinced that Hong Kong in the next decade, will both be an important contributor, as well as major beneficiary to the significant financial sector changes in China. We can see this in the banking field, as well as the debt market field. There is much to be done to prepare Hong Kong for this important role, but that I believe that should be the theme of another speech.

Thank you.

Table 1 - Emergence of Chinese Economic Area

(Gross Domestic Product)
(in trillion US dollars)

  Market Prices   Standard International Prices  
  1991 2002 1990 2002
Chinese        
Economic Area 0.6 2.5 2.5 9.8
U.S. 5.5 9.9 5.4 9.7
Japan 3.4 7.0 2.1 4.9
Germany 1.7 3.4 1.3 3.1

Note: Standard international prices are based on purchasing power parity.

Source: World Bank "Global Economic Prospects and the Developing Countries", 1993. Quoted in Nomura Asia Focus, January 1995.

Table 2 - Major Countries' Emergence into the World Economy

  United States Japan China Chinese Economic Area
  1870-1900 1950-1980 1980-2010 1980-2010
Growth of GDP 3.9 7.7 8.1 7.9
Share of world output at outset 15.4 3.2 3.6 4.2
Share of world output at end 25.7 10.1 15.4 17.1
Change in share 10.3 6.9 11.8 12.9
Share of world exports of manufactures at outset 3.8 3.4 0.8 3.3
Share of world exports of manufactures at end 14.7 11.2 6.4 10.3
Change in share 10.9 7.8 5.6 7.0

Source: World Bank (August 1994)

Table 3 - East Asian Experiences of Rapid Growth

  Japan South Korea Taiwan China
  1950-80 1960-90 1960-90 1980-2010
Growth of GDP        
1950-60 8.5 - - -
1960-70 10.0 9.3 9.1 -
1970-80 4.5 8.5 9.5 -
1980-90 - 9.6 7.7 8.9
Whole period 7.7 9.1 8.8 8.1

Source: World Bank 1994.

Table 4 - Size of Financial Markets: % of GDP at 1992-93 Average

  M2/GDP Bond Debt Outstanding     Equity Market capitalization
    Gov't Private Total  
US 63 47 58 105 66
Japan 110 43 25 68 67
Germany 72 34 44 78 23
UK 96 28 14 42 109
Korea 42 - - 26 39
Taiwan 170 - - 9 69
Thailand 82 - - 5 81
Hong Kong 108 3 - 3 257
China 96 6.4 3.3 9.7 8

Note: 1992 figures for Asian Economies.

Source: Various, compiled by HKMA.

Table 5 - Financial Sector Scenario for 2000: China, Hong Kong and Taiwan

  1994 2000 2000(4)          
  GDP   M2/GDP   Stock Market   Bond Market  
  US$ bn US$ bn % US$ bn % US$ bn % US$ bn
China 550 1,700 110 1,870 40 680 40 680
Hong Kong 130 300 120 360 300 900 25 75
Taiwan 220 5505 170 935 100 550 25 138
Total 900 2,5506   3,165   2,130   893
  1. Nomura Research Institute, "China Economic Development and its Implications for Asia and the World Economy", Nomura Asia Focus, January 1995
  2. A. Boltho, U. Dadush, D.He and S. Otsubo, "China's Emergence - Prospects, Opportunities and Challenges", World Bank Policy Research Working Paper, 1339, August 1994.
  3. Tsong-shian YU, "Prospects for the Economic Relationship across the Taiwan Strait", Chung-Hua Institution for Economic Research, March 1995.
  4. Market size are scenarios based on author's estimates.
  5. Forecast by Ji Chou "The Taiwan Economy in the Year 2000", Chung Hua Institution for Economic Research, December 1993.
  6. World Bank estimates of US$2516 bn by Year 2002, Paul Armington and Uri Dadush, "The Fourth Growth Pole", June 1993.
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Last revision date : 28 April 1995